Raising the Social Security Payroll Tax Cap Does Not Fix Social Security

About the Author

Is a fix for Social
Security even worth discussing if it would only delay the system's
inevitable shortfalls by six or seven years? Groups such as AARP
think so and have proposed raising the payroll tax cap to make the
wealthy pay their "fair share" for Social Security. But this would
only patch the system's finances for a few years, rather than
solving the problem for good. And that's not the worst of it.
Raising the tax cap would raise taxes for many middle class
families, impose a tremendous burden on small business, slow the
economy, and cost jobs. In short, raising the payroll tax cap would
make Social Security an even greater burden than it is today.

Currently, workers
pay Social Security payroll taxes on only the first $90,000 of
their annual income. This "wage cap" is indexed to the growth of
real wages in the economy and increases every year. The wage cap
serves to limits the amount of Social Security benefits that a
well-off retiree will receive. Even though Bill Gates and Donald
Trump earn millions of dollars a year, for the purpose of
calculating Social Security benefits, they earned just $90,000 in
2004.

Using the message that "Those who have
benefited from the growth in the economy should be asked to pay a
little more to help secure Social Security," groups such as AARP
call for raising the amount of income subject to Social Security
payroll taxes from $90,000 to somewhere between $125,000 and
$200,000. AARP, which favors a $140,000 cap, claims that this
simple move would "solve" 43 percent of Social Security's projected
shortfalls.[1]

Polls show that raising the wage cap has some
popular support. A February 10, 2005, Washington Post poll
showed that 81 percent of those questioned supported raising the
income cap.[2]
Respondents might be more skeptical, however, if more people knew
what AARP isn't telling them: raising the wage cap is no fix. It
would postpone Social Security's problems for only a few
years.

A recent report from the Social Security
Administration (SSA) examined the effects of not just raising the
wage cap, but of eliminating it completely.[3] Under this radical
approach, Bill Gates and Donald Trump would pay Social Security
taxes on every dollar that they earn. They would also receive
benefits on those earnings. The scoring memo also examined a still
more radical proposal: that people would pay Social Security taxes
on all of their income but receive benefits only on income below
$87,900, the wage cap that was used in the SSA study.[4] This would be a major
shift from the current policy that Social Security benefits are
based on a worker's taxable income. Still, neither of these
policies would improve Social Security's cash flow very much, and
both are much more ambitious than AARP's plan.

SSA's actuarial study showed that that
eliminating the payroll tax cap entirely would only delay the start
of Social Security's annual deficits by six years, from 2018 to
2024. Eliminating the wage cap on payroll taxes while paying
benefits on only the first $87,900 of earnings would delay the
start of annual deficits by an additional year, to 2025.

As well, these policies would delay the onset
of massive deficits by only a few years. As Social Security now
stands, annual deficits will first reach $100 billion a year (in
2003 dollars) in 2022, according to the 2003 Social Security
trustees report.[5]
Eliminating the wage cap delays $100-billion deficits until 2029,
or only seven years. On the other hand, subjecting all earnings to
payroll taxes but only paying benefits on income up to the current
wage cap delays the start of those $100-billion deficits until
2031.

If completely eliminating the wage cap only
delays deficits by six or seven years, how could just raising it to
$140,000 solve a significant part of Social Security's financial
problems?

Another problem with raising the wage cap is
that for every taxpayer with an income of over $500,000 affected by
raising the tax cap to $125,000, 27 taxpayers with lower incomes
would pay higher taxes, too.[6]
In 2001, the majority of taxpayers earning more than $90,000 had
incomes between $90,000 and $150,000. Only a very small number of
the 130 million tax returns filed in 2001 (0.3 percent of
taxpayers) showed income between $500,000 and $1 million, and an
even smaller number (0.1 percent) showed incomes of over $1
million.

Raising the cap to $125,000 would directly
increase taxes for 7 million middle-class families. Going to the
$140,000 advocated by the AARP would cost many of these families
even more. At up to an additional $2,650 in taxes per year, this
change might not mean much to millionaires, but the families who
would bear the brunt of this tax increase would surely
suffer.

Perhaps the most significant impact of raising
the wage tax cap would be on small-business owners and the
self-employed. Small firms and individual entrepreneurs are the
driving force of rapid innovation and economic growth in the United
States. Small-business owners would have to pay higher taxes on
behalf of all their workers were the wage tax increased, and they
might have to spend more on salaries, too, to make up the drop in
workers' take-home pay. The self-employed would face a direct tax
hike twice as great as other workers because they pay both side of
the payroll tax.

No surprise, a higher tax cap would sap
economic growth and destroy job opportunities. A 2001 report from
the Center for Data Analysis modeled the economic impact of
eliminating the cap on wages subject to the payroll tax.[7] The results of this
small change-actually the largest tax increase ever-would be
severe:

Reduce the take-home pay of 10.4 million workers by thousands of
dollars, decrease family savings by thousands of dollars, and
reduce investment by hundreds of billions of dollars;

Decrease the rate of economic growth significantly, shaving
hundreds of billions of dollars from the U.S. GDP; and

Reduce the number of job opportunities and increase
unemployment.

In other words, lifting the wage cap would be
quite expensive in terms of its effect on the economy and on
millions of individual workers and families.

Raising the wage cap has been greatly
oversold. It would directly increase taxes for millions of
middle-class families who can ill afford to give up even more of
their paychecks. It would increase benefits for the wealthy, who
scarcely need the extra money. And it would harm the economy,
slowing growth and job creation, as well as impacting millions of
families' savings. Worst of all, for all these terrible effects,
raising the wage cap would push Social Security's massive
shortfalls only a few years into the future. Social Security is
already a bad deal for most Americans and a burden for younger
generations. Raising the wage cap would make it worse.

David C.
John is Research Fellow in Social Security and Financial
Institutions in the Thomas A. Roe Institute for Economic Policy
Studies at The Heritage Foundation.